Improving the capital project allocation process

Improving the Capital Project Evaluation Process
AFP Annual Conference 2006

Jim Robertson
Director, Corporate Planning & Performance Management
October 17, 2006

© 2006 James A. Robertson, Jr.

Agenda
• Structuring Discount Rates: A Practical Perspective
• COC
• Business Risk
• Project Risk
• Capital Allocation
• Linkages to Strategy
• Portfolio Optimization
• Summary

Objectives
• Make decisions about future investments based on the fundamental economic
principle that value is created by earning more than the cost of capital.
– Focus on cash investment and return
• “It’s cash flow that counts, not how you count it”
• “Until a business returns a profit greater than its cost of capital, it operates
at a loss” Drucker
– Use net present value and payback as key financial decision criteria for all
investments.
• Provides a common financial measure for comparing investments across
the company.
– Use discount rates that reflect risks specific to BU’s and project types
– Allocate capital to strategic priorities

• Rationale
– Investor expectations for future value
• NPV measures the incremental value an investment adds to the company
– Better understanding of the financial impact of strategy
– Increased visibility into business for top management
– Improved expense control

Discount Rate = COC + Bus Risk + Project Risk

Discount Rates Have 3 Components
Corporate Required Rate of Return
Discount Rate: Cost of Capital: Business Risk: Project Risk: The
minimum rate of return
The rate used to The average cost of The minimum rate of
required for a specific
calculate the NPV a firm’s debt and return required on the
project. The hurdle
of all expected equity capital. entire portfolio of
rate should take into
inflow and outflows capital projects.
The COC equals the account the corporate
of an investment
rate of return that a At a minimum, the required rate of return
= company must earn
+ acceptable rate of
+/- plus any project
in order to satisfy the return should equal specific risks. The
demands of its the cost of capital. hurdle rate is used to
owners and creditors compare with a
project’s internal rate
of return.

 At the corporate level, the returns for the entire portfolio of capital projects should exceed
the COC in order to create economic value.
 At the BU level, the return on an individual project may be less than the discount rate
depending on the BU strategy.
 Hurdle rates may be higher than the required rate of return depending on the likelihood of
the project being completed as planned and generating the results which were used to
justify the investment. Hurdle rates may be differentiated across BU’s or project types


Business & Project Risk Methodology
Business Unit Business Risk
– Management
Project Risk
– Predictability
– Competitive Factors

Risk Defined: Risk Points
 Completion: Likelihood
of a project being
completed as planned. Risk COC
 Outcome: Likelihood
that project will generate +
the results which were
used to justify the Corporate COC
investment.
=
Discount Rate Specific to
BU and Project Type


Cost of Capital Methodologies: CAPM
• Cost of capital is first of 3 components in the discount rate: average cost of
a firm’s debt and equity capital.
• Defined
– Cost of equity is a function of risk-free rates, plus a premium to reflect
the extra risk of an investment
– Premium is the historical difference between the risk-free rate and the
rate of return of the stock market as a whole multiplied by an number
reflecting volatility of the stock (beta)
• Advantages
– Used for over 40 years essentially unchanged
– Accepted broadly in industry as the standard measure of cost of capital
• Disadvantages
– Lack of empirical data proving this rate is used by the market to
discount a company’s projected cash flows to a present value.
– Market risk premiums are assumptions and vary by firm (e.g., Goldman
equity premium is 350 basis points, Accenture uses 500 basis points)
– Beta is a historical measure, and not a forward looking measure of a the
risk to the future cash flows of a company.
– Many bankers and executives find beta an unreliable estimate of a
stock’s risk:
• 1998: before Steve jobs returned, Apple cost of equity of 8% vs.
IBM 12%


Non CAPM Approaches: Market-Derived Capital Pricing Model
• Defined
– Cost of capital reflects three types of risk:
• National confiscation risk: country policies (e.g. confiscation,
inflation = Government bond rate for a given time period
• Corporate default risk = premium above corporate bonds that
corporations pay
• Equity returns risk = traded prices of equity options which reflect
best market estimates of future price volatility.
• Advantages
– Theoretically appealing as a better solution than CAPM
• Incorporates market’s best estimate of future price volatility instead
of using historical data.
– Discount rates can be more intuitively realistic than CAPM rates
• Disadvantages
– Methodology created by Pacifica Strategic Advisors
– Not widely accepted
– Lack of empirical data proving this rate is used by the market to
discount a company’s projected cash flows to a present value.


Non CAPM Approaches: Empirical
• Defined
– Discount rates used by the market to discount expected future cash
flows of a company.
– Rates can include both market and company-specific rates
– Examples include Cash Flow ROI and Warranted Value model by
HOLT/CSFB, Attive Research (formerly Callard & Madden).
• Advantages
– Empiric evidence that these rates are used by markets, both US and
international, to discount future cash flows.
– Applies equally to all companies regardless of business model or asset
intensity.
• Disadvantages
– Variety of different approaches, most tied to proprietary valuation
models.
• Maintenance of market and company-specific data requires
significant expertise and resources to continually update data on
market and company discount rates.
– Approaches less applicable to early stage/fast growth companies
– Rely on unique methods of projecting cash flows that require involved
calculations:
• Requires focused corporate staff training
• Implementation issues.

Approach

• Adopt CAPM to calculate the Corporate cost of capital.
– Update semi-annually to reflect changes in risk-free rates and beta.
– At some point evaluate empirical approaches.

• In high growth companies, you will miss the boat by debtating
whether a project exceeds the COC by 1 or 4 points
– This is what happens in mature companies in mature industries where
the major opportunity for value creation is in improving profitability.

• Focus on implementation


Business & Project Risk Methodology
Business Unit Business Risk
– Management
– Predictability
Project Risk
– Competitive Factors

Risk Defined: Risk Points
 Completion: Likelihood
of a project being
completed as planned. Risk COC
 Outcome: Likelihood
that project will generate +
the results which were
used to justify the Corporate COC
investment.
=
Discount Rate Specific to
BU and Project Type


Qualitative evaluations drive quantitative risk modifiers to cost of capital
• Identify risk factors which differentiate the likelihood of a project being completed as
planned and generating the results which were used to justify the investment
– Business Risk: Differences between BU’s
– Project Risk: Differences between types of projects
– Determine weightings for Business and Project Risk
• Business Risk 70%
• Project Risk 30%
• Qualitatively rate BU and Business Priority Area risk and assign risk points.
BU Risk Points BPA Risk Points
Low Risk 0 0
Mod Risk 10 4
High Risk 20 8

• Quantitatively translate total risk points into a modifier which is added to Corporate
COC to calculate a discount rate specific to BU and Business Priority Area.
• Discount rate applied to any project capped at 220% Corporate Cost of Capital.
Total Risk Points Discount Rate
0-3 16%
3.1-6.0 19%
6.1-9.0 22%
9.1-12.0 26%
12.1-14.9 29%
15.0-17.9 32%
18.0 + 35%

Business Risk: Factors
• Business Risk is the second of 3 components in the discount rate,
and measures the risks of:
– Completion: Likelihood of a project being completed as planned.
– Outcome: Likelihood that project will generate the results which were
used to justify the investment.

• Business Risk is specific to a business unit within the company and
how its risks of compare to other BU’s (relative), not other
companies (absolute):
– Internal: Management (Completion)
– Internal: Predictability (Completion, Outcome)
– External: Competitive Factors (Outcome)


Business Risk: Management
• Right Leader
– Strategic vision and ability to get team enthusiastic
– Teambuilding skills
– Enabler
– Industry experience
– Commitment to and practice of management development
• Right Direct Reports
– Top notch skills and experience
– Business acumen
– Ability to motivate
– Ability to delegate
• Right Team
– Trust in senior management team by employees
– Team coherence and experience together


Business Risk: Predictability
• Key Metrics: actual vs. plan/approved forecast

• P&L: actual vs. approved forecast

• Meet deadlines

• Understand customer requirements and how these rapidly change

• Impacted by BU and corporate business processes and ability to measure
and forecast key metrics and business results.
– For example, strong confidence in forecasting process can increase
certainty in a forecast and reduce the risk of making future investments.


Business Risk: Competitive Factors
• Competitive strength:
– Degree to which BU leads the industry: Is it #1 or #2?
– Gaining or losing market share?
– Degree of reliance on external partnerships (positive/negative potential
impacts)

• Pricing Stability
– Degree to which BU is woven into competitors’ business model and
process
– Barriers to entry
– Competition basis: price, quality, reliability
– Contract length

• Smart competitors or dumb competitors

• Rate of change
– Customer needs
– Products
– Technologies
– Product obsolescence


Business Risk
• Risk factor weighting

Management 50%

Predictability 25%

Competition 25%

Total 100%


Business Risk: Risk Points
Risk Factors
Internal External
Competitive RISK
Management (50% Predictability (25% Advantage (25% POINTS
Weight) Weight) Weight) (Weighted)
Rating Points Rating Points Rating Points
BUSINESS UNIT

Division A
BU 1 Low Risk 0 Mod Risk 10 Mod Risk 10 5.0 (1)
BU 2 Mod Risk 10 High Risk 20 Mod Risk 10 12.5

Division B
BU 1 Mod Risk 10 Low Risk 0 Low Risk 0 5.0
BU 2 Low Risk 0 Mod Risk 10 Low Risk 0 2.5
BU 3 Mod Risk 10 High Risk 20 Low Risk 0 10.0

Division C Mod Risk 10 Low Risk 0 Mod Risk 10 7.5
0
Corporate
Functional Area 1 Low Risk 0 Mod Risk 10 NA 2.5
Functional Area 2 Low Risk 0 Low Risk 0 NA 0.0

(1) .50 x 0 + .25 x 10 + .25 x 10 = 5 Risk Points


Project Hurdle Rates: Factors
• Project Risk is the third of 3 components in the discount rate, and reflects
the likelihood of a project being completed as planned and generating the
results which were used to justify the investment.
– Certainty of Completion.
– Certainty of Outcome
• Identify risks specific to the nature of the project and how its risks of
compare to other types of projects.


Project Hurdle Rates: Risk Points

PROJECT TYPE

1.0 Market 2.0 Productivity & 3.0 Quality &
Development Cost Improvement Reliability 4.0 Facilities 5.0 IT

Rating - Draft
Certainty of Completion High Risk Mod Risk Mod Risk Low Risk Low Risk
Certainty of Outcome High Risk High Risk Mod Risk Low Risk Mod Risk

Risk Points
Certainty of Completion 4.0 2.0 2.0 0.0 0.0
Certainty of Outcome 4.0 4.0 2.0 0.0 2.0
Total 8.0 6.0 4.0 0.0 2.0


Business & Project Risk Matrix: Total Risk Points
PROJECT TYPE

1.0 Market 2.0 Productivity & 3.0 Quality & BU Risk
Development Cost Improvement Reliability 4.0 Facilities 5.0 IT Points

BUSINESS UNIT

Division A
BU 1 13.0 (1) 11.0 9.0 5.0 7.0 5.0
BU 2 20.5 18.5 16.5 12.5 14.5 12.5

Division B
BU 1 13.0 11.0 9.0 5.0 7.0 5.0
BU 2 10.5 8.5 6.5 2.5 4.5 2.5
BU 3 18.0 16.0 14.0 10.0 12.0 10.0

Division C 15.5 13.5 11.5 7.5 9.5 7.5

Corporate
Functional Area 1 10.5 8.5 6.5 2.5 4.5 2.5
Functional Area 2 8.0 6.0 4.0 0.0 2.0 0.0
Functional Area 3 8.0 6.0 4.0 0.0 2.0 0.0
Functional Area 4 8.0 6.0 4.0 0.0 2.0 0.0

Project Risk Points 8.0 6.0 4.0 0.0 2.0

(1) 5 Business Risk Points + 8 Project Risk Points = 13.0 Total Risk Points


Using Risk Points to Calculate Discount Rates
• Total BU + Project Risk Points used to calculate a Risk Rate Modifier
which is applied to Corporate COC.
– Highest discount rate allowable is 220% of Company COC.
• Discount Rate Table:

Total Risk Points Risk Rate Modifier VRSN COC Risk COC Discount Rate
0-3 0% 16% 0% 16%
3.1-6.0 20% 16% 3% 19%
6.1-9.0 40% 16% 6% 22%
9.1-12.0 60% 16% 10% 26%
12.1-14.9 80% 16% 13% 29%
15.0-17.9 100% 16% 16% 32%
18.0 + 120% 16% 19% 35%


Business & Project Risk Matrix: Discount Rates
PROJECT TYPE

1.0 Market 2.0 Productivity & 3.0 Quality &
Development Cost Improvement Reliability 4.0 Facilities 5.0 IT

BUSINESS UNIT

Division A
BU 1 29% (1) 26% 22% 19% 22%
BU 2 35% 35% 32% 29% 29%

Division B
BU 1 29% 26% 22% 19% 22%
BU 2 26% 22% 22% 16% 19%
BU 3 35% 32% 29% 26% 26%

Division C 32% 29% 26% 22% 26%

Corporate
Functional Area 1 26% 22% 22% 16% 19%
Functional Area 2 22% 19% 19% 16% 16%
Functional Area 3 22% 19% 19% 16% 16%
Functional Area 4 22% 19% 19% 16% 16%

(1) 13 Total Risk Points = 13.0% Risk COC + 16% VRSN COC = 29% Discount Rate


Distribution of Discount Rates Appears Reasonable
Distribution of BU and Corporate Discount Rates

14
# of BU/Project Combinations

12

10

8 BU & Corporate

6 BU Only

4

2

0
16% 19% 22% 26% 29% 32% 35%
Discount Rate

• BU & Corporate distribution appears reasonable
– Standard distribution
– BU projects have more risk than corporate projects, and also has a standard distribution
• Opportunities to make investments in a broad range of risk categories

Strategy Focused Organization

2. TRANSLATE STRATEGY 1. MOBILIZE CHANGE THROUGH
TO OPERATIONAL TERMS EXECUTIVE LEADERSHIP
• Create a corporate scorecard • Create a climate for change
 Strategy Map • Create the Leadership Team
 Measures • Create the vision and strategy
 Targets • Create team accountability
 Initiatives • Change the culture

3. ALIGN THE 5. GOVERN TO MAKE
ORGANIZATION STRATEGY STRATEGY A CONTINUAL
TO THE STRATEGY PROCESS
FOCUSED
• Create business/shared (VSS) • Link budgeting and planning to
services unit scorecards ORGANIZATION strategy
• Create sub-business/shared • Conduct Strategy Review Meetings
services unit scorecards • Actively manage initiative portfolios

4. MOTIVATE TO MAKE
STRATEGY EVERYONE’S JOB
• Communicate the strategy
• Align HR Programs to strategy

Source: Balanced Scorecard Collaborative

Using VPM to Manage Strategy Execution

Longer Term (3-5 year) View Shorter Term (Annual) View
Vision Strategy and Map Resource
Mission Objectives Measures Targets Initiatives Milestones Accountable Budget
Alloc

Financial
• Grow high- • % revenue • ‘04 xx%
F1
margin from high-
To provide top-notch healthcare to our

• ‘05 xx%
margin
Be the community hospital of choice

service
F2 services • ‘06 xx%
Customer
• Provide • Customer • Develop • Survey drafted • Mkg. • $ xxxx
• ‘04 xx%
personalized satisfaction organization- by 6/04 Team
C1 •
community

care survey rating ‘05 xx% wide survey
• ‘06 xx%

• Keep patients • Service level • Electronic • Complete by • Dept. Chairs • $ xxxx
Internal

P1 informed spot check • ‘04 xx% notes project 2004
P2 rating • ‘05 xx% • All patients
• ‘06 xx% logged in
Learning

• Provide • % new • ‘04 xx% • Learning • Deadline • HR • $ xxxx
technology technology • ‘05 xx% assessment met Committee
& resources used by staff project
L4 • ‘06 xx%

Strategy “Leadership” Tactics “Management”


Resource Allocation: Where the Rubber Meets the Road

Strategic
Objective
Each objective is measured to track
performance and facilitate strategic discussion.

Measu
re
Each measure receives a target to determine
the level of performance required to succeed.

Target
Each Objective is supported by initiatives
(activities, projects, and resources) to ensure
that the organization is capable of delivering on
the targets that underpin the objective.

Initiatives

Internal

People &
Financial

Customer

Knowledge
Perspective

resources
Partnering
Objectives

performance
management
development
development

Price performance

Integrate and align

People and change

Individual and team
Sales and customer

Focused technology

Perfect manufacturing
Economic value added

Strategic competencies
Pick the winners globally

Customer sensitive culture
Create new market demand
sev t a ti n t nerr u C
i i i

ng se der t ne m r uc o P
i e r Be the lowest cost producer
y ge art s s ekr a mgn g e m
t t i r E

sr e nn w e h hi wr e n r a P
i t t t

e nac rr uh dna L & Wdna ces se R
i

not ac fi t ne d s dee n y il a u Q
i i i t

m e es uac t oo r o c o p y il a u Q
il r f r t

n ot a u m o e R
i l r f

se tili ca / not az l a cr e mm c VS
i f i i i o

o p gn kcart t n a p m c r e m t s u C
r i i l o o

s p hsr e n r a p PV ml e d S
i t / a i
objectives
serving no
2 initiatives

n a hc e u av n t ne m c na hne T
i l i e I

not a ne ml p m P OCS
i t e i

mA
b

CS B e dacsac po eve D
/ l

no s v e a c nu m m C
i i t i o

se tili ca not a m o er a s A
i f i r f i

t ne m gl a y ge art s T
ni t I

v o p m ssec o p kr o w r par c S
r i r e

m r go pt ne m v o p m d e Y
a r e r i l i

e dar gpu se tili ca F
i

r e C. g mn ser AN 20009 OS
f i I

s mt sys t r e px E
e

ml p mt ne m o eve d s d a w R
e i/ pl r e

s not ac nu mm cl a bo G
i i o l

sli ks c ge art s gn n ar T
l i t i i
Managing Initiatives Can be a Demanding Manual Process

No initiatives
9 initiatives

for this objective
for 1 objective

Imperative to Improve Ability to Allocate Capital and Other Resources
in Complex Environments
▪ Business models are becoming increasingly complex.
– Acquisitions, geography, customer needs
– Clear and concise linkages between strategy, financial plans, and daily
operations is key to executing a growth strategies
▪ With many opportunities for investment, the more important it t becomes to
use standardized, enterprise-wide processes that allow initiatives & projects
to be identified, evaluated, and ultimately managed across BU’s and
geography.
– Optimize investments across BU’s
– Move towards real-time planning
• Need for ongoing evaluation and reallocation of resources to
respond to the competitive environment

Comprehensive Initiative Management
Demand to Completion
Corporat Corporate Mission & Strategy
e
Strategy
Corporate Objectives

Initiative Management

Portfolio
Demand
Measures & Mgmt
Management Program Management
Targets
Stratex Project Management
Non Project
Specific Resource Management
Resources

• Provides direct link between strategy & projects • Standard financial baseline, track spending and
• Executive visibility/dashboard to all portfolios, resources
programs and projects • Consolidation capability of all programs and projects
• Single portfolio/program and project repository • Captures investment regardless of GAAP classification
• Standard and consistent processes,
expense/capital
methodologies and flowcharts at the macro
levels • Standard of project performance and linkages to
strategy across the company for resource allocation

Demand and Portfolio Management Overview
Demand
Management Approved
New Product
Approved Existing
Approved
Infrsastructure
Product Ideas
Ideas Ideas
Idea Prioritize & Approve

1st Gate Approval

Business Ops
Council Approved
Proposals
Proposal Review High Level Approve Refine Estimates/
Business Business Case Submit for
Case Planning
Architecture & Standards
Board

Manage Portfolio

Costs, Budgets,
Benefits
Develop
Portfolio Portfolio
Portfolio Options Scenarios

Management Resource
Supply vs.
Demand

Steering
Approved
Committee
Projects
Approval
Value vs.
Risk

Risk
Value

Demand/Portfolio Management

Enter Proposal for New Project
Capture Estimated Cost
Capture Estimated Resources
Drive the Evaluation Process
Provide Visibility through a Real Time
Dashboard

Out-of-the box templates to capture project
proposals, value and risk rating,
processes, business case, ROI and more.

Templates can be configured to capture
information unique to customers.


Enter Proposal for New Project
Capture Estimated Cost
Capture Estimated Resources
Drive the Evaluation Process
Provide Visibility through a Real Time
Dashboard

Configurable scoring criteria to evaluate
project proposal values and risk.

Adjustable weights for each scoring
criteria.

Demand Management: Portfolio Programs and Projects

Portfolio Management: Scenario Analysis

Portfolio Management- Identifying Projects to Fund based on
Risk/Reward Profile

Budget Summary Views by Portfolio Scenario

Governance Process - Not the Tool - is Key to Managing Initiatives

• PMO Director, PMO
– Strategic, centralized
– Process ownership Portfolio Managers
– Project Managers report functionally to PMO
– Aligned to business by portfolio Program/Project Mangers
• Governance Organization
– Enterprise Portfolio Hierarchy Business Analysts
– Steering Committee
– Membership formalized
• Key functions included Governance
– Align BU – IT – Process Board
• Business Relationship Approval Authority
Managers
• Standards Committee
Project Review Board (PRB)
Prioritization, Budget, Technical,
– Governance
Staffing and Schedule Review
– PLC
Project Life Cycle (PLC) Teams
EXECUTION

Improving the capital project allocation process

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